We’re going to be discussing standard deviations and bollinger bands more fully in the coming training, because they are a critical part of the Iron Condor strategy. Your bollinger bands on your chart are most probably set to 2 standard deviations for the upper and lower band. In simple terms for this analysis, anything outside 2 standard deviations is highly unlikely. We expect, with 98% certainty, that price outside the upper or lower bollinger band will move back to a 1 or 0 deviation.
When price action is more balanced, you notice the bands are “tighter” meaning the range of possible prices is not very wide. When markets are hot and growth accelerates, you’ll notice the bands expand creating more room for the standard deviations to include all possibilities of price. But it’s not only the upper band that expands, the lower one does as well.
How the Fed contributes to a “too hot” economy
In the years since the creation of the Federal Reserve in 1914, the Fed has sought to involve themselves in the market more and more and the ever expanding boom-bust cycles of the economy are the resulting world we live in. Jerome Powell accurately stated equities were overpriced a year ago, yet somehow has seen to reason lowering interest rates and expanding the Fed’s balance sheet as a reasonable thing to do while we are at the highest levels our economy has ever seen.
I believe there are a lot of reasons to see assets increase ever higher but a few things are troubling. From a fundamental perspective, we know QE4 is being used to fuel this increase in equity prices. It is a bubble completely of the Fed’s making, and in the process is limiting the tools available to the Fed to minimize casualties during an actual downturn… For example, the Fed funds interest rate is currently 1.75, but in 2000 before the dot com crash was over 6.5%, leaving the Fed room to lower rates in the down turn to attempt to stir the economy. A similar situation existed in 2008, but rates remained at the same level of near 0 for almost eight years. Moving into 2020, there will be no room to use rates to stimulate an economy in recession.
The other tool available to the Fed is literally create money out of thin air, aka “quantitative easing” wherein the Fed injects liquidity through a couple different markets. This expansion of available currency goes directly to the banks, in hopes that it will be lent out and with low rates stimulate the economy and provide banks with the stability needed to do so. When times are better, the Fed will reverse the liquidity injections slowly so the literal printing of money does not effect inflation so adversely that it is felt by consumers.
How is this any different than 2008?
However, the Fed’s balance sheet is still 4x bigger than what it was pre-2008. The injections made by the Fed have not been felt by consumers. Much like in 2000 and 2008, the money is going to banks and they are using it to make themselves richer at the expense of a meltdown. Notice how unemployment is at record lows, but CPI is not rising? So where is that money going?
The stock market. It’s 2008 all..over…again. Banks are taking the free money they are getting from the Fed, and boosting the stock market to get even fatter. Just like when AIG took the government bailout money and promptly threw the biggest party they had ever had. So what does this have to do with bollinger bands? Okay, with that in mind, let’s look at some charts.
The 2000 and 2008 bubbles
This is the dot com bubble and subsequent crash in monthly candles. It took about five years to build before prices fell over 50% over the course of about 2-3 years. The dashed lines are upper/lower bollinger bands, solid line is the 20ma. You’ll notice the market pierced the upper bollinger band several times which is an indication of how “hot” the economy was. SPX saw only one break of the 20ma, and no touching of the lower band, until the crash was already underway.
As price expanded and the bands with it, the more extreme the upper price the more extreme the lower prices became.
In 2008 it was very similar
Between 2003 and 2007, the Fed helped create a giant bubble with equities nearly doubling in a very short period of time.
I think we have a similar, but different, set of circumstances creating a bubble in 2020. There usually exists a catalyst to expose the bubble and send prices tumbling and I don’t believe we are there yet at all. But I want us all to not be ignorant to the underlying similarities, and realize the resulting recession will be similar to or worse than 2008 because the tools usually used by the Fed to try and save the economy from a recession will be unable to be used.
My theory (the Austrian theory) is those tools do nothing to help recessions, but in fact create them. Unfortunately I believe we are in the beginning of watching that theory play out.
Bollinger bands pull prices
My point is we are seeing the bollinger bands expanding again after 2018’s pullback led to some tightening of the bands in 2019. You can liken this to 2008, except instead of prices continuing to fall the Fed stepped in and prices have accelerated higher. Instead of balance, we got expansion. In many ways that has been good, but in the end it will come with a price.
Any time we’ve seen the monthly candle close so far outside the upper bollinger band the way December’s did it’s been an indication of the economy getting too hot.
Again, the upper band represents 98% of price probabilities. You can’t live in the 2% zone, there is a 98% chance we see prices in the short term recede some. I’ll keep watching the monthly candles, but looking in the past this typically goes on for a while before we see them retreat to the lower band. A more balanced market would retreat to more balanced price as it did in 2018 after getting too hot. To allow the market to cool down some. What we can learn from 2000 and 2008 is if there isn’t a proper cool down, and the market is too hot for too long, the melt up tends to have a resulting melt down.
For us, here, we will be ready. Our strategy works in either type of market and since prices usually fall faster than they rise, we can make money faster in a melt down than in a melt up. But take note of the signs, and understand the market needs balance. Getting too hot is not a good thing long-term